Most financial plans are built around numbers that don’t measure what matters.
A portfolio that grows 7% annually sounds stable. A salary that rises 3% each year suggests progress. But neither figure answers the question that determines actual outcomes: what can this capital buy, now and later?
The difference between nominal growth and purchasing power is not a technical footnote. It is the gap between planning based on illusion and planning based on reality.
What Purchasing Power Measures
Purchasing power describes the quantity of goods and services a unit of currency can acquire. It declines when prices rise faster than the nominal value of money or assets.
A portfolio worth $100,000 today and $107,000 next year has grown nominally by 7%. But if inflation during that period was 4%, the real increase in purchasing power is approximately 3%. The additional $7,000 does not buy 7% more—it buys roughly 3% more than the original sum could have purchased.
This distinction compounds. Over decades, the divergence between nominal figures and actual purchasing capacity becomes structural, not marginal.
The Arithmetic of Erosion
Inflation does not subtract evenly. It distorts the relationship between effort, accumulation, and utility.
Consider a simple case: $50,000 saved today, untouched, with 3% annual inflation.
| Years Passed | Nominal Value | Purchasing Power (Real Value) | Erosion (%) |
|---|---|---|---|
| 0 | $50,000 | $50,000 | 0% |
| 10 | $50,000 | $37,205 | 25.6% |
| 20 | $50,000 | $27,680 | 44.6% |
| 30 | $50,000 | $20,587 | 58.8% |
The nominal balance remains static. The capacity to consume diminishes by more than half.
This is not a hypothetical risk. It is the baseline condition for currency held without offsetting real return.
Nominal Returns Are Not Real Returns
Investment returns are typically quoted in nominal terms. A bond yielding 5%, a stock portfolio returning 8%, or a savings account offering 2%—all describe growth before purchasing power adjustments.
The real return is what remains after inflation:
Real return ≈ Nominal return − Inflation rate
If a portfolio earns 6% nominally and inflation averages 3%, the real return is approximately 3%. That 3% represents the actual increase in what the capital can purchase.
The formula is approximate because compounding effects interact, but for most practical ranges, the subtraction holds closely enough to guide decisions.
Example: Two Portfolios Over 20 Years
Two individuals each invest $100,000. One earns 8% nominal returns, the other 5%. Both face 3% inflation, giving them approximately 5% and 2% real returns respectively.
Compounding at these real rates over 20 years:
| Portfolio | Nominal Return | Real Return | Real Value (20Y) | Real Gain |
|---|---|---|---|---|
| A | 8% | ~5% | $265,330 | $165,330 |
| B | 5% | ~2% | $148,595 | $48,595 |
Portfolio A’s purchasing power after two decades is 79% higher than Portfolio B’s—not just in nominal account balance, but in actual command over goods and services.
The initial return gap of 3 percentage points compounds into a structural difference in purchasing capacity that cannot be closed by later adjustments.
Where the Gap Appears
Purchasing power erosion is not uniform. It surfaces unevenly across spending categories, time horizons, and financial structures.
Housing and Healthcare
Certain expenses—housing, healthcare, education—have historically risen faster than general inflation. Planning based on aggregate inflation rates understates the erosion in categories that dominate long-term budgets.
A retiree relying on fixed income indexed to 2.5% inflation may find healthcare costs rising at 5% annually. The mismatch does not appear immediately, but over 15 years, it becomes a funding shortfall that cannot be closed by nominal adjustments.
Currency Depreciation Events
Inflation is typically measured as an average. Averages obscure periods of acute depreciation—years where inflation spikes to 6%, 8%, or higher. These episodes compress purchasing power faster than moderate returns can restore it.
Capital that compounds at 4% real loses significant ground during a year of 7% inflation. Recovery is possible, but not automatic. The setback persists unless structural adjustments are made.
Planning Backward From Real Needs
Financial planning built on nominal targets—”I want $2 million by retirement”—assumes purchasing power remains stable. It rarely does.
A more durable approach works backward from real requirements:
- Estimate actual spending needs in today’s terms
- Project those needs forward using realistic inflation assumptions for relevant expense categories
- Determine the real return required to sustain purchasing power at those levels
- Structure allocations to target that real return, accounting for risk and volatility
This inverts the usual framing. The goal is not a nominal balance, but sustained purchasing capacity over the horizon that matters.
Example: Retirement Income in Real Terms
An individual plans to retire in 25 years and estimates needing $60,000 annually in today’s purchasing power.
Assuming 3% inflation, that $60,000 requirement becomes approximately $125,730 in nominal terms at retirement. To sustain that for 30 years, accounting for continued inflation, requires a portfolio generating real returns consistently above drawdown rates.
If the portfolio yields 5% nominal and inflation averages 3%, the real yield is roughly 2%. Withdrawing 4% nominally erodes principal in real terms. The shortfall accumulates.
This table illustrates the directional impact, though precise outcomes depend on sequence and timing:
| Withdrawal Rate (Nominal) | Real Return | Illustrative Outcome Over 30 Years |
|---|---|---|
| 4% | 2% | Principal erodes ~45% in real terms |
| 3% | 2% | Roughly stable purchasing power |
| 5% | 2% | Principal depletes critically |
The nominal withdrawal rate must align with real returns, or purchasing power collapses long before nominal balances do.
Asset Allocation and Real Returns
Different asset classes generate different real returns over time. The variation is not minor.
Equities have historically provided real returns in the range of 6-7% over long periods. Bonds, depending on duration and credit quality, have delivered 2-3% real. Cash and short-term instruments often fail to keep pace with inflation, delivering near-zero or negative real returns.
Allocation determines whether a portfolio preserves purchasing power, grows it, or quietly surrenders it.
| Asset Class | Historical Real Return (Long-Term Average) | Volatility | Purchasing Power Outcome |
|---|---|---|---|
| Equities | ~6.5% | High | Significant real growth |
| Bonds (Investment) | ~2.5% | Moderate | Modest real growth |
| Cash / Short-Term | ~0% | Minimal | Erosion under typical inflation |
A portfolio weighted heavily toward low-real-return assets may grow nominally but shrink in purchasing terms. The comfort of stability comes at the cost of capacity.
Inflation as a Structural Constraint
Inflation is not an external disruption. It is a permanent condition of fiat currency systems. Central banks target specific inflation rates—typically 2%—as policy objectives. This is intentional.
The implication: purchasing power erosion is designed into the system. Planning that ignores it misaligns with the environment capital operates within.
Real returns must exceed inflation persistently, or capital loses its function over time. This is not alarmism. It is arithmetic.
The Cost of Delay
Purchasing power planning has a time penalty. Starting later compresses the horizon over which real returns can compound.
Consider two individuals, both targeting the same real retirement income:
- Individual A begins investing at age 30, contributes $10,000 annually, earns 5% real returns for 35 years.
- Individual B begins at age 40, contributes $10,000 annually, earns 5% real returns for 25 years.
| Starting Age | Years Invested | Total Contributions | Real Value at 65 |
|---|---|---|---|
| 30 | 35 | $350,000 | $986,000 |
| 40 | 25 | $250,000 | $477,000 |
Individual A accumulates more than double the purchasing power despite contributing only 40% more nominally. The difference is not effort—it is compounding time applied to real growth.
Delay does not reduce purchasing power linearly. It reduces it structurally.
Why This Is Rarely Emphasized
Nominal figures are simpler to communicate and psychologically easier to process. A portfolio that “grew to $500,000” feels tangible. A portfolio that “maintained $320,000 in real purchasing power” sounds technical, even though the second statement is more informative.
Financial institutions often present nominal performance because it appears stronger. A 7% nominal return sounds better than a 4% real return, even when the latter is the relevant measure for planning.
This is not deception, but it creates misalignment. Investors celebrate nominal milestones while purchasing capacity deteriorates unnoticed.
Implications for Long-Term Planning
Purchasing power is not an abstraction. It is the outcome that determines whether accumulated capital performs its intended function: funding consumption when income ceases or declines.
Plans built without explicit attention to real returns, inflation-adjusted needs, and category-specific cost trends are plans built on shifting ground.
The correction is not complex:
- Define goals in real terms, not nominal balances
- Structure allocations to generate real returns above required drawdown rates
- Monitor inflation exposure in spending categories that matter most
- Adjust periodically as inflation outcomes diverge from assumptions
These steps do not guarantee outcomes. They align planning with the mechanics that govern purchasing power over time.
Takeaway
Numbers that grow nominally but shrink in purchasing terms create the illusion of progress while delivering stagnation. Real returns are what capital can do, not what it appears to be worth.
The difference compounds silently. Over decades, it separates plans that preserve capacity from plans that deplete it.
Purchasing power is not a secondary consideration. It is the primary one.
